Wells Fargo And Binary Interest Rate Expectations

Summary

With large banks, the talk of regulation and interest rates commands the daily conversation.

This article focuses on higher interest rates as a binary event.

When you put the scenarios into a long-term context, decision making can be quite a bit easier.

With big banks, there are a couple of basic notions that are always working in the background: regulation and interest rates. I've previously talked about the regulation side (and how it may not be as bad as it first appears). Today, I'd like to focus on the rate side.

There's a simple answer as to whether we'll see higher (or materially higher) rates in the next say 5 to 10 years. The answer is either "yes" or "no." I'm not trying to be funny. Either it happens or it doesn't, and you can have a view on it, but that doesn't make it any more or less likely. Naturally, there are a whole lot of in-between possibilities (slightly higher, higher then lower, lower for longer and then eventually higher, you name it), but that's the basic construct that we're working with. The answer to "will we see higher rates?" is either "yes" or "no" and the actual outcome is not yet known.

What's interesting to me is that acknowledging this lack of clarity actually makes the investing process a whole lot easier. I'll show you what I mean using Wells Fargo (NYSE:WFC) as an ongoing example.

Let's first suppose that rates stay low for some time. In the past three years, Wells Fargo has earned between $21 billion and $23 billion annually. Obviously, another recession or adverse event could come about, but the company has proven its earnings power in "normal" times to be north of $20 billion.

Should rates remain near zero, this does not simultaneously imply that Wells Fargo's growth must stagnant as well. This happens for a couple of reasons.

First, stagnant company-wide growth does not necessitate stagnant per share growth. Should the number of common shares outstanding increase or decrease, earnings-per-share growth is going to be different from company-wide growth. In the case of Wells Fargo, the company has a net payout ratio target of between 55% and 75%.

The company is currently paying out a $0.38 quarterly dividend. Expected earnings for this year are around $4.10 per share. That equates to an anticipated dividend payout ratio of about 37%. In turn, this leaves approximately ~20% to ~40% of the company's profits left for share repurchases. Should Wells Fargo earn $20 billion, that implies $4 billion to $8 billion available for potential share repurchases. As a point of reference, over the past three years Wells Fargo has spent an average of $7.8 billion on share repurchases (closer to $5.9 billion on a net basis).

The current market capitalization of Wells Fargo is less than $250 billion. This means that perhaps 1.5% to 3% of the shares could be retired in a given year. This isn't going to be a linear process, but the propensity is certainly there. It should be noted that the issuance of shares could very well offset some of this benefit. Taking these items collectively, under current circumstances, it's not unimaginable that Wells Fargo could retire a percent or two of its shares annually.

The second aspect of potential company growth comes from the possibility of loan growth and returns on capital. Banks earn returns on capital, of which they distribute a portion - but not all - to shareholders. The remainder can be used to strengthen the business and ultimately earn returns itself. Moreover, even with the same rate of profitability, an increase in the amount of loans increases profits.

When coupled with the prospect of share repurchases, it's not unimaginable that Wells Fargo could grow per share earnings by say 3% annually, even in a "poor" operating environment of lower rates and increased regulation. Let's see what this could mean for a potential investment today.

Three percent annual earnings per share growth could equate to earnings of $5.60 or so after a decade. Should shares trade with a similar earnings multiple as today (just over 11 times earnings) that would equate to a future price of about $63. If the dividend grew in line with earnings per share (thus, keeping the payout ratio the same, and offering ample earnings for share repurchases and a strengthened business), you might anticipate receiving $18 or so in cash payments.

In total, today's investor might anticipate a future value near $81, keeping in mind that this is merely a baseline using the assumptions detailed above. This equates to a total annualized return of 5.6% per annum. Let's round down and call it 5% per year.

Now certainly this is nothing to text home about. Yet I'd like to point out that it's not exactly a terrible result either. This is a rather poor case - 3% annual growth based on an expectation of a decade's worth of low rates - and yet a $10,000 starting investment could turn into $17,000 or so after a decade.

Next let's think about a reasonably upbeat scenario - one in which rates are higher and banks in general are able to earn a good amount more on the same capital. Perhaps not back to the pre-recession marks, but still quite a bit higher than today. For intermediate-term growth, I've seen estimates for Wells Fargo ranging from 5% to over 9%. Let's call it 7% for this example.

If Wells Fargo were able to grow earnings per share by 7% annually, you'd anticipate that the company could be earning $8.20 or so after a decade. Based on the same trailing multiple as today, that would equate to a future share price near $92.50. If the dividend were to grow at the same rate, you would anticipate collecting $22.50 or so in cash payments.

In total, your expected per share value would be about $115. Expressed differently, your expected total gain would be about 9.4% per annum. We'll call it 9%. As a point of reference, that's the sort of thing that would turn a $10,000 starting investment into $24,000 or so after 10 years.

This example presumes faster overall growth, but it's still below a lot of analysts' estimates, without seeing a higher P/E ratio still presumes a payout ratio below 40% and doesn't include the ability to reinvest along the way.

Next you'd likely want to think about the likelihood (in your personal opinion as it relates to a potential investment) of the two scenarios detailed above. As a baseline something in the 5% to 9% range - with preference being toward one side or another, depending on your view - seems like a reasonable place to begin.

Naturally, the actual returns may be much higher or lower, but that's how I'd begin to think about an investment in Wells Fargo. In an adverse scenario (slow growth), you're still looking at the prospect for reasonable returns. A lot of people get caught up in the everyday rate talk, but if you take a long-term view, things generally even themselves out.

And should a bit of growth formulate (not to mention the potential for faster dividend growth or a higher earnings multiple, which was not detailed above), it's easy to see that quite solid returns can be had. The idea is to create a reasonable baseline, make a personal judgment and then distance yourself from the common short-term psychological missteps that are frequently presented.

Disclosure:I am/we are long WFC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.